Exchange-traded products pose an “emerging risk” to UK retail investors and there is evidence of poor practice among UK product providers, according to the UK's Financial Services Authority (FSA).

In its Retail Conduct Risk Outlook 2012(RCRO), released yesterday, the regulator defined emerging risks as those where there was “evidence of poor conduct in firms but little or no evidence yet of widespread consumer detriment” and where it believed the issues could grow.

It highlighted a lack of clear labelling as an issue for retail investors, and said that many did not fully understand the risks involved. “Investors are exposed to the changes in the market the ETP is trying to track, as well as a number of risks arising from the structure of the ETP itself. Consumers or their advisers may not fully understand ETPs and consumers may therefore suffer detriment if they are sold a product unsuitable to their risk appetite,” it said in the report.

Many in the industry are likely to be unsurprised the regulator has listed ETPs as an area of concern, particular given the warnings it has issued over the past year, which have included a proposal to ban the sale of synthetic ETFs to retail investors.

The FSA has said in the past that it anticipates that the implementation of the Retail Distribution Review, which aims to remove commission bias from investment advice, will lead to a greater retail investment in ETFs and with that due to come into force at the end of this year, its efforts to ensure investors are properly educated are perhaps to be expected.

The FSA had also included ETFs as an issue in last year’s Retail Conduct Risk Outlook, although in this year’s document it appears to have widened its area of concern to cover the entire ETP market, rather than focusing on UCITS-regulated funds.

“The ‘ETP’ label describes many products that have a wide range of structures, with some investing in riskier and more exotic markets,” it said.

Townsend Lansing, head of regulatory affairs at ETF Securities, says this broadened approach is likely to have come as a response to the industry’s calls for regulators to look beyond ETFs in their scrutiny. “This is not a surprise. It is entirely consistent with the overall discussions about ETFs, which have extended into making sure that regulators understand the whole market of exchange-traded products. If you look at the responses to both the first and second ESMA consultations, it was clear that people were saying that legislation across exchange-traded products should be harmonised. UCITS is not the right place to look at an ETC for example, which is not a fund. On that basis this would seem a continuation of that theme and shows that they recognise the need to widen the discussion of risk and appropriate structure to other exchange-traded products.”

iShares’ EMEA head Joe Linhares says the issuer is among those that had called for regulators to look at the entire ETP space. “We also highlight the distinction between fund and non-fund exchange-traded products and encourage regulators to cooperate, ensuring a level playing field is maintained for products and more importantly, that investors know exactly what they are buying and any attendant risks.”

MJ Lytle, managing director at ETF issuer Source, says the inclusion of ETPs as an emerging risk in the FSA document could even be viewed in a positive light: “They might have described it as an emerging risk because UK retail have never been big buyers of ETFs before. Actually I would see this as a high quality problem because you have an asset that is seeing increased interest from retail investors and the FSA are saying that before the likely buying happens in earnest, they want to make sure that, if there are any little niggles in the system, that they iron them out. That’s how I would read it.”

It’s possible the widening of the FSA’s focus also signals a move away from the physical versus synthetic debate that dominated discussions about the merits of ETFs last year, particularly given the fact that ESMA declined to recommend a split between the two types of fund in its January consultation paper.

The FSA’s statement about poor practices in UK firms, however, is more difficult to interpret. In last year’s report, the regulator stated a plan to ramp up its supervision of the industry, and in this year’s RCRO it said: “Over the last 18 months, we have conducted thematic visits to a number of firms who account for a significant portion of the EU ETP market. We found some evidence of poor practice in UK-authorised firms and have asked firms to address risks where we have found issues.”

The FSA declined to elaborate on the firms or the poor practices to which it was referring when contacted by IndexUniverse.eu.

Lansing says it is unclear which arm of the ETP industry the FSA was focusing on in this regard. “It is hard to know how far and how wide they have defined the scope of what an ETP is and whether that conduct they refer to relates to the issuer side or the marketing and distribution side.”

However, taking into account the introduction set out in the RCRO, it seems reasonable to speculate that it may be the latter the regulator has in its sights. “This document sets out the priority risks arising from firms’ conduct in their direct relationship with retail customers, or where firms have a direct duty to retail customers. This document does not contain a general discussion of wholesale conduct risks,” said the FSA.

The FSA said it would continue to work with both UK and other EU bodies to mitigate risks in the ETP industry and to work towards a coordinated EU approach.